Extent to which the carbon price will be sufficient
to drive low-carbon investment, in particular decarbonisation
of energy

1. Our analysis suggests that the carbon
price is the backbone of climate change policyand its existence
both facilitates some of the transition and enhances the credibility
and consistency of complementary climate policy instruments. If
we are to decarbonise the power sector, large-scale deployment
of renewables must play a central role (Neuhoff, 2007b). Without
tailored support schemes in addition to the carbon price, the
market is unlikely to choose "the right" technologies
(Neuhoff and Twomey, 2008). Thus tailored support scheme for renewables
are required. Our analysis has illustrated the advantage of feed-in
type systems over the ROC scheme (Butler and Neuhoff, 2008)and
we have explored how the UK could structure a transition to such
a scheme, while maintaining investment security and enhancing
economic effectiveness (Johnston, Kavali and Neuhoff, 2008). Success
will depend not only on the financial support scheme for individual
projects, but will require changes to market design, planning
and administrative procedures. For low-carbon technologies to
succeed and reduce costs, the expectation and confidence of technology
companies, in the growth of future demand for their technology,
facilitates investment and enhances innovative activity (Neuhoff,
Lossen, Nemet, Sato and Schumacher, 2007, Foxon, Kohler and Neuhoff,
2008, Neuhoff). The European Renewables Directive creates a target
and reporting framework to address these concerns, and the long-term
expectation in growing demand for new technologies in a carbon
constrained worldas formulated with ETScan further
enhance market success.

Impacts on and responses by UK firms covered by
the EU ETS

2. We have pursued surveys across management
and investors in the UK and across the EU to better understand
the response of private sector investors to carbon EU ETS (Neuhoff,
2007a). We find that one needs to differentiate between investorsand
tailor the design of climate policy and EU ETS to match their
requirements. Strategic decisions of large corporations and pension
funds might be driven by long-term targets and their credibility
that can be reinforced with a stringent EU ETS design. The associated
uncertainties are too high for technology companies, which are
more focused on specific policy design for renewable energy. In
contrast, project investors are often focusing on the direct impact
of the carbon price on the viability of their projects, and are
therefore more concerned about short-term volatility and uncertainty
associated with the carbon price. We combined and compared several
models to illustrate the range of uncertainty of projections for
carbon emissions (Neuhoff, Ferrario, Grubb, Gabel and Keats, 2006).

3. The analysis points to three aspects that
need to be considered in the design of emission trading. First,
a clear and simple framework, preferably with full auctioning,
enhancing the visibility of the scheme, and reduces uncertainties
associated eg with future free allowance allocations. Second,
the ability of future carbon prices to rise to levels that are
necessary to meet future emission reduction targets is important.
It enhances the credibility of government policies, and facilities
projections of future market shares and opportunities. Price caps
or safety valves, in contrast, undermine this visibility and would
be difficult to determine, given the uncertainties about future
coal, gas, oil and technology prices. Also, clear limits on the
use of international off-sets are important to create visibility
of emission reduction objectives (and technology opportunities)
within Europe (Neuhoff, 2008a). Third, given increasing evidence
on the carbon price uncertainty and volatility (Grubb, 2008),
policy instruments to ensure a price floor can facilitate project
investment using bank finance and thus reduce finance cost. This
can be achieved with the use of a reserve price in allowance auctions
(Hepburn, Grubb, Neuhoff, Matthes and Tse, 2006), or by governments
issuing long-term physical option contracts on future carbon prices
(Ismer and Neuhoff, 2009).

Implications of the EU ETS for business competitiveness,
and how to address them

4. Together with Climate Strategies we convened
and pursued extensive studies on the implications of emission
trading for European Competitiveness (Grubb and Neuhoff 2006).
Given the broad range of aspects that influence the competitiveness
of an economy, or more operational, a sector of the economy, we
decided to move to analysis that focuses on leakage effectsdefined
as the direct impact of unilateral carbon pricing on investment,
operational or closure decision of an economy. Detailed quantitative
analysis of the sector specific impact across all manufacturing
industries in the UK pointed to a narrow set of activities that
could potentially be at risk of leakage (Hourcade, Neuhoff, Demailly
and Sato, 2008).

5. Several approaches have been proposed to address
such leakage concerns. Sectoral agreements received much attention
in international discussions, but both their politics and economics
make them unlikely candidates to address leakage concerns. Given
the sensitivities associated with international discussions on
competitiveness, sectoral cooperation might be enhanced if it
is not intended to address leakage concerns. (Colombier and Neuhoff,
2008). Free allowance allocation is the second instrument that
is argued to be suitable to address leakage concerns. The challenge
is, that in order to address leakage concerns, the allocation
has to affect investment, operation and closure decisions and
thereby distort the carbon price signal and environmental effectiveness.
This points to the need of carefully balancing leakage concerns
and domestic efficiency (Grubb and Neuhoff, 2006).

6. Direct provision of state aid is a third
option to provide support towards investors that face higher carbon
costs in Europe than in other parts of the world, and both legal
and economic aspects are discussed in detail in Neuhoff and Matthes
(2008). The economically efficient approach to address leakage
concerns are border adjustment. In Ismer and Neuhoff (2007) we
argue how careful implementation can overcome WTO constraints
and limit administrative complexity. The political sensitivities
of border adjustment are the real barriers for its implementation,
and have to be carefully considered and addressed (Neuhoff, 2008b).
International cooperation to limit the use of border adjustment
(Neuhoff and Ismer, 2008) offers the opportunity to address concerns
of developing countries about proliferation or discriminatory
application of border adjustments, concerns of the trade community
about technical constraints and complicities of inhomogeneous
application of border adjustment, and ensures that the use of
border adjustment is manageable in political processes in developed
countries.

Allocation or auctioning of EU ETS credits, and
the use of auctioning revenues

7. With analytic models we have demonstrated
the significant distortions that repeated free allocation of allowances
creates (Neuhoff, Grubb and Keats, 2005). For the case of the
power sector, detailed simulation models point to the cost increases
associated with these inefficiencies (Neuhoff, Keats and Sato,
2006). Comparison across the national allocation plans that were
announced for phase II (and subsequently implemented with only
small alterations to the allocation methodology) highlights the
empirical relevance of the academic concerns (Neuhoff, Rogge,
Schleich, Sijm, Tuerk, Kettner, Walker, Ahman, Betz, Cludius,
Ferrario, Holmgren, Pal, Grubb and Matthes, (2006). As a result
the revisions to the EU Directive envisage full auctioning for
the power sector (other than in new member states), and prescribe
a harmonised European allocation using benchmarks for other installations.
The complications of such benchmarks are discussed in Neuhoff
and Matthes (2008) and are likely to fuel much discussion during
2009.

8. The design of auctions, as a more efficient
allocation methodology was always clear, and the theoretical literature
pointed to the simple design options (Hepburn, Grubb, Neuhoff,
Matthes and Tse, 2006). Detailed analysis, based on experience
from other sectors and from industry participants, confirmed these
assumptions and lead to a simple straw-man for the auction design
(Neuhoff, 2007c), that is in line with the approaches that have
emerged since. The forthcoming debate will have to focus on approaches
to coordinate or integrate auctions across European countries,
so as to increase simplicity and robustness of the European Emission
trading scheme. The use of auction revenues will need to balance
the interest of treasuries to balance the debt accrued when bailing
out the badly regulated financial sector, with environmental objectives.
In addition, with potentially higher carbon prices, distributional
implications for poor households will have to be addressedwhich
can be achieved with a fraction of the auction revenue if well
targeted (Neuhoff and Matthes 2008).

Development of a global carbon market

9. Multiple trajectories can potentially
result in a long-term convergence to a global carbon markets.
This can involve different design options to link schemes (see
Neuhoff, 2008a) or build on top-down approaches. The quantitative
analysis points to huge uncertainties of base line emissions in
countries like China (Neuhoff, 2008c) that would prevent any attempt
of direct linking of emission trading schemes, pre 2015 or 2020.
The uncertainty could only be managed if private sector agents
would be prepared to invest in and bank CO2 allowances valued
at hundreds of billions of dollars. This is, however, a very unlikely
scenario.

10. It seems important to build international
frameworks based on the specific requirements of emerging and
developing economies to pursue effective climate policies (Neuhoff
2006). In the project International support for domestic climate
policies, country case studies explored the drivers and barriers
for individual policies in developing countries, and the type
of support they would require for faster, more ambitious and more
encompassing implementation (Neuhoff, 2008c). The detailed analysis
points to the importance of using intermediate indicatorsthat
not only measure the direct emission reductions achieved with
a specific policy, but already provide feedback about effective
implementation, possible barriers, and success of transformational
policies and activities.

11. The changing perspective is increasingly
reflected in international discussions, with the G77 and China
proposal for Technology Action Plans that can encompass a set
of National Appropriate Mitigation Actions (NAMAs). This approach
offers emerging economies and developing countries the opportunity
to enhance their institution capacity and stakeholder support
in the field of environmental and technological policies, and
can thus create the basis against which these countries can eventually
take absolute targets and participate in broader emission trading
schemes.

12. Two direct implications for the design
and implementation of the European Emissions Trading scheme are:

(a) a reduced role for CDM project mechanisms.
As long as the project mechanism offers the opportunity for stakeholders
to benefit personally from project credits, further action is
unlikely to be pursued. Also, the support tends to go to carbon
and energy intensive sectors, and thus prevents a shift towards
lower-carbon activities; and

(b) an increased importance of auctioning and
hypothecation of auction revenue. In the absence of emission trading
with developing countries, developed countries (Annex 1 countries)
have to find other mechanisms to make resources available to account
for their differentiated (historic) responsibility. Taxation of
international aviation and shipping can provide some resources,
but a credible commitment to use some of the auction revenue for
support of domestic action in developing countries is probably
necessary to provide the resources that are perceived to be necessary
(eg financial flows calculations by UNFCCC).

25. Neuhoff, K 2008b, The Political Economy of
a World with Different Carbon Prices, in Competitive distortions
and leakage in a world of different carbon prices, study complied
on study compilation on requested by the European Parliament's
Temporary Committee on Climate Change.